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Everyone knows that the higher your credit score, the better off you'll be. But, how are credit scores calculated, and what can you do to maximize yours?

A dash of regular payments and a sprinkle of credit history! Source: Olga Pavlovsky.

We all know that when it comes to credit scores, higher is better. The most widely used credit score, the FICO score, is computed by a super-secret formula, but the Fair Isaac(NYSE:FICO) company (who owns the FICO score) has given some clues.

According to the company, the formula for the FICO score is as follows: 35% payment history, 30% amounts owed, 15% length of credit history, 10% new credit, and 10% types of credit. That's a little helpful, but what makes a "good" score within each individual category? How many credit cards should you have? Are is it really as bad as I've heard to make a credit inquiry? Let's see if we can break down what really makes a good credit score.

Payment historyThe obvious advice here is to pay all of your bills on time. While it is pretty common knowledge missed payments and delinquent accounts stay on your credit report for seven years, it is not well-known that recent payments are weighted higher in the formula.

The exact weighting is anyone's guess, but what this means is that just because you have a few missed payments, or even charge-offs, it is still very beneficial to pay on time from here on out. Even though the bad information will linger, it will count less and less as time goes on.

Amounts owedIt is not as simple as keeping your balances as low as possible. More importantly in calculating your score is evidence that you are using your available credit wisely. The FICO people define a "high achiever" as someone with a score of 785 or higher, and high achievers have three credit cards with balances, on average. However, those balances represent just 7% of their total available credit limit.

In other words, it is important to use your credit cards, but keep your balances relatively low. Having no credit card balances is worse that high balances in many cases.

Length of credit historyEverybody has a credit history from the time they turned 18, so this is kind of a tough one to figure out. Fortunately, Fair Isaac has given some insight into the credit histories of those with the best scores. It turns out the average high achiever's oldest account is 19 years old, and the average age of all of their accounts is between six and 12 years.

So, if you have a "starter" credit card with a low limit that is in good standing, don't close it just because you qualify for "big-kid" credit now. It can help your score to keep your older accounts open. Just don't run a balance on cards like that, if you can help it. Carry your small balances on the cards with the lowest interest rates and best benefits. You'll be surprised how sweet some of the card benefits get as your credit improves!

New creditAccording to myfico.com, only about 28% of high achievers (almost one out of three) apply for new credit in any given year. This goes hand-in-hand with the "length of credit history" issue. A new account will bring the average age of your accounts down. It is not the worst thing in the world to apply for credit, especially if it is a step up in terms of the type of account, but try to limit the inquiries on your credit report to one or two per year.

Types of creditThe key here is diversity. As I said before, the average "high achiever" has three credit cards, but has six open accounts in all, including mortgages, car loans, and other installment accounts. Basically, lenders want to see that you will use any type of credit responsibly.

What's NOT a part of your credit score?It is worth mentioning some things that have no bearing on your credit score. Salary is the big one that plays no role, but other things like age, employment history and "soft" credit inquiries have no impact on your score. So, payment histories being equal, a $25,000 per year worker has no credit disadvantage to a $250,000 per year executive.

Final thoughtsOne of the most important things you can do to put yourself in the best position to build your credit score over time is to take an active role. You should monitor your credit regularly, and there are services that will alert you when anything on your report changes. Each of the three major credit bureaus is required by law to give you a free copy of your credit report once a year, so take advantage of that!

In the meantime, pay all of your bills on time, and don't be afraid to use your credit cards once in a while.

Author

Matt brought his love of teaching and investing to the Fool in 2012 in order to help people invest better. Matt specializes in writing about the best opportunities in bank stocks, REITs, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!
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